The possibility of running out of money is one of the biggest risks that retired investors face. A simple-but-clever approach to combining risk-profiled funds can greatly increase clients' chances of enjoying a good retirement.
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Planning to invest in retirement can be like entering a looking-glass world where much seems backward and contrary to lifelong investment instincts. As the table below highlights, there are real differences between saving for retirement (accumulation) and drawing benefits (decumulation), both in terms of investment objectives and risks.
Risk-profiled multi-asset funds are popular in retirement portfolios as investment options to help address the challenges of providing regular income over an unknown and potentially long period of time. A typical approach is to invest in a fund that matches the client's risk profile (for example a balanced fund) and draw income solely from that fund.
Relying on one type of risk-profiled fund may not be the best option in the long run. Here we look at a different type of strategy, where money is invested across a range of investment funds that are lower, equal to and higher than the client's risk profile.
By combining funds with different risk profiles and applying a frequent rebalancing discipline there is the potential to create more robust portfolios for providing income throughout retirement. The strategy we outline here could help provide clients with increased protection against sequencing risk and volatility drag, whilst maintaining the same overall risk rating.
Accumulation vs decumulation
|Converting income into capital||Converting capital into income|
|Fixed term horizon||Unknown time horizon|
|Investing for growth||Investing for income|
|Increasing capital||Reducing capital|
|Pound cost averaging can be beneficial||Pound cost 'ravaging' is a risk|
Andrew, age 67, is now entering retirement. He receives his full state pension but would also like to achieve an annual income of £12,000 which rises with inflation by investing his savings of £300,000.
To achieve an income of 4% per year, Andrew has many investment choices open to him. However, with an outlook stretching to 30 years and beyond, he needs to consider the likelihood of his money running out in retirement.
Canada Life Asset Management have modelled the likelihood of Andrew's drawdown pot lasting 30 years, based on three common approaches to investing at retirement:
- Investing solely in a low-risk model.
- Investing based on Andrew's risk profile (risk profile 5*).
- Investing based on Andrew's risk profile but including a cash buffer of two years' worth of income.
Based on historical average performance and volatility of each risk profile*, assuming an initial investment of £300,000 and a starting monthly income of 4%, rising at 2% per year to account for inflation, a Monte Carlo simulation run 1,000 times was used to calculate the chances of Andrew's money lasting 30 years.
If Andrew's pension was invested in the risk profile 5 fund, which reflects his risk profile, there is around a 13% chance that his money will run out within 30 years, based on a £300,000 investment.
However, the apparently lower-risk alternatives above do not improve Andrew's chances. Investing in the risk profile 5 fund while retaining a cash buffer of two years' worth of income slightly increases his risk of running out of money within 30 years. Meanwhile, investing solely in the lowest risk profiled model portfolio carries the highest risk of running out of money.
Combining risk profiles to create a more robust portfolio
Using the same model, Canada Life Asset Management looked at what might happen if Andrew's pension was invested in a combination of risk profiled funds to create an overall risk profiled 5 model portfolio, instead of solely investing into one fund. For simplicity, if we invested Andrew into a risk profile 3, 5 and 7 fund (33% in each) we can still have an overall risk rating equivalent to a risk profile of 5.
Using the '3-5-7' strategy, as opposed to a single fund, the likelihood of Andrew's money lasting 30 years increased from 87% to almost 94%, highlighting how managing decumulation risks can improve chances of money lasting without affecting Andrew's risk profile.
In order for the bucketing strategy to work two things must happen:
- The income must be taken from the fund with the lowest volatility, in this example fund 3.
- The portfolio must be rebalanced at least quarterly, in order to maintain the initial split between funds 3, 5 & 7. In the example above the portfolio was rebalanced quarterly, in line with the risk profiling tool used.
In rising markets, rebalancing means the amount invested in pot 3 is likely to be 'topped up' by better performance from the higher volatility 5 & 7 funds.
In a downturn, the lower volatility 3 fund's unit price is likely to fall less than the unit price of the more volatile funds in 5 & 7, and because income is taken only from 3, the effect of pound cost ravaging is reduced.
Applying the strategy in The Retirement Account (TRA)
Canada Life's The Retirement Account provides risk profiled funds and the necessary infrastructure to apply this risk-management strategy to clients' in-retirement investments. The success of the strategy relies on three components:
- The ability to invest in a range of risk profiled funds that align to specific asset allocation guidelines which ensure that they never deviate from the expected risk levels.
- The ability to set up regular rebalancing to ensure that the percentage split between funds doesn't deviate over time.
- The ability to select a specific fund from which to take income.
We have ten risk-targeted portfolios available in The Retirement Account, five active and five passive. The funds align to Dynamic Planner's asset allocation guidelines for risk profiles 3 to 7 to ensure they never deviate from their level of risk (reviewed daily and rebalanced as required).
The Retirement Account offers a flexible automated rebalancing feature that can provide monthly, quarterly or yearly rebalancing (at customer level), or on an ad-hoc basis.
For income payments, you can provide instructions to our Customer Service Team as to which investment fund (if you have more than one) you would like us to sell in order to make income payments.
*Source: Canada Life Asset Management & Morningstar. Figures based on an equal weighted benchmark consisting of every primary share multi asset OEIC/Unit Trust which has been risk profiled or risk targeted by Dynamic Planner to 31/12/2020, split into each of their risk profiles.
The simulation was based on a Monte Carlo Simulation using Brownian Motion, run a thousand times to assess possible outcomes of returns, using the 5-year return and standard deviation of the equally weighted benchmarks. Income was deducted monthly, after growth for the month. Income was based on the initial sum and grew by 2% in value annually. Chance of running out was based on the number of times the simulation hit -100% in value, divided by 1000. The 357 model is based on the same equally weighted benchmarks and using same returns as the single benchmarks, but with the investment split equally between benchmark 3,5 and 7. The 357 portfolio was rebalanced quarterly back to its initially weighting. Cash bucket used the same returns as benchmark 5 and utilised a cash holding of two years’ worth of starting income, topped up annually to the initial percentage.
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Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate.
The information contained in this document is provided for use by investment professionals and is not for onward distribution to, or to be relied upon by, retail investors.
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Canada Life Asset Management is the brand for investment management activities undertaken by Canada Life Asset Management Limited, Canada Life Limited and Canada Life European Real Estate Limited. Canada Life Asset Management Limited (no. 03846821), Canada Life Limited (no.00973271) and Canada Life European Real Estate Limited (no. 03846823) are all registered in England and the registered office for all three entities is Canada Life Place, Potters Bar, Hertfordshire EN6 5BA. Canada Life Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Expiry 12/04/2022 CLI01858